Going through a down round isn’t ideal, but plenty of startups have successfully leveraged one — or several — on their way to success. Whether you’re considering this option because of internal factors (like lackluster financial performance) or external ones (like market conditions), you want to maximize benefits and mitigate risks. And that means carefully evaluating what the down round will mean for your company.
We’re here to help. As CPAs who specialize in supporting startups, we’ve been through down rounds with many of our clients. We want to give you a brief overview based on our experience, specifically delving into how the down round affects your accounting and your taxes.
Down round 101
To get us all on the same page, let’s quickly look at down rounds in general.
This means you’re going through a round of fundraising with a pre-money valuation that’s lower than the post-money valuation of your previous round. In other words, your company is now worth less than it was at the end of your last round of fundraising.
It’s not a great look. It might signal financial distress and dampen employee morale. But there are ways to get through a down round and use it to propel you to the next stage of success. That lower price point can open your startup up to a whole new field of investors. You might get opportunities that wouldn’t have existed before.
You just need to be extremely mindful of key issues like dilution and relationships with investors from your previous rounds. We have some tips to help you approach the down round with accounting and taxation best practices in mind.
What a down round means for your accounting
To start, you need to make sure that lower valuation is accurately captured in your startup’s financial statements. There are two places you may need to make this tweak: on your balance sheet and on your income statement.
Then, you need to look at any instruments that require you to report fair market value. You might need to revalue your convertible preferred stock, for example. Make accounting adjustments to mark down instruments wherever needed to bring them in line with fair value based on your new, lower valuation.
Now comes the tricky part: figuring out dilution. Here, the accounting implications of a down round really hinge on whether your previous rounds with investors extended anti-dilution protection.
If you didn’t, accounting for your down round is pretty simple. It means calculating the dilution for all of your existing shareholders based on their equity in the new value of the company. But with provisions for down rounds in place, things get more complicated.
How anti-dilution measures play out during down rounds
Many investors require safeguards in case your startup goes through a down round. If they have preferred shares, they have a leg to stand on to make sure those shares include anti-dilution provisions. These measures help them avoid losses even if your company valuation drops.
Generally, these provisions come in one of two forms, with weighted average more frequently used:
- Weighted average: In this case, the conversion price of the investor’s preferred shares gets adjusted based on the number of new shares you’re issuing and their price. This protects some of the valuation of their ownership stake, but they will still see some level of loss during your down round.
- Full ratchet: This option gives the investor the most protection. With full ratchet anti-dilution protection, the conversion price of that investor’s preferred shares gets adjusted to the down round price of new shares. This means they get more shares to keep the valuation of their ownership stake at the same level.
While weighted average anti-dilution provisions mean founders and other shareholders fare better, neither of these options are ideal for any party other than the investor getting the protection.
Ultimately, a down round means dilution, but with these special provisions for preferred shareholders, founders, option holders, and common shareholders all take a bigger hit.
Your accounting needs to explore all of this and clearly lay out the equity breakdown based on how the dilution shakes out. Dilution might mean lower earnings per share (EPS), for example, which you need to disclose on your financial statements.
Recording instruments with anti-dilution provisions
This is a bit of an aside, but since it relates, we’ll call it out.
Things can get complicated when it comes to recording shares with down round protection on your books. Under Accounting Standards Update 2017-11 from the Financial Accounting Standards Board (FASB), you don’t necessarily always need to classify financial instruments with down round features as liabilities. They can still potentially be equity, but it’s all based on certain criteria. Talk with your accountant to get clarity about how these kinds of shares should all get entered into your accounting system.
The tax implication of a down round
Some of the tax considerations of a down round hinge on the jurisdiction(s) in which your company operates, but we’ll highlight some overarching implications.
For starters, to stay compliant, you need to make sure your disclosures and filings all reflect your new valuation.
Then, look at:
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- Tax deferrals. If you deferred tax assets on your balance sheet (like a net operating loss carryforward or an R&D credit), they may or may not be recoverable based on the new expectation for future profits. Your accountant can help you figure out if you need a valuation allowance.
- Section 409A. If you issued nonqualified deferred compensation to employees (e.g., restricted stock units [RSUs], stock options) and the down round affects them, you might need to take certain steps to stay in compliance with this part of the Internal Revenue Code.
- Ownership changes. If dilution during your down round results in an ownership change, it can impact how you’re able to use past net operating losses to offset future taxable income, along with other carryforwards.
The one upside? If you or your investors feel the burden of capital gains taxes, the capital losses that come with a down round might eat into them, reducing your overall tax liability.
These are just a few of the high-level considerations when it comes to accounting and taxes during a down round. To dig into the details and ensure you’re taking the right steps to minimize dilution, issue the right disclosures, and stay tax compliant, meet with an expert.
Our team here at ShayCPA can come alongside you, applying our startup expertise to help you manage your down round. Contact us to get started with support during this important season in your startup’s trajectory.